If advisers were asked to name those investment strategies which have been “on trend” over the past five years, then factor-based investing would almost certainly feature.
Asset management groups have been serving up a growing number of these funds to pension trustees since the global financial crisis, after the performance of traditional linear asset classes fell out of favour.
Initially, investors were seeking an investment that managed volatility. As such “Min Vol” products were among the first to become widespread. But as academic studies investigated the behaviour of assets during the crisis, other signals became the basis for new funds.
Today common factors such as “value” – unloved stocks which appear to be cheap, “momentum” – assets which are on the up because they’re in favour and “quality” – companies which have top notch fundamentals, have become the most common in funds offered by asset managers. And it’s fair to say that pension funds have been queuing up to buy them. “We have already seen pension schemes commit to factor-based investing over the past five years in particular, although factor-based strategies have been live for at least a decade now,” says SSGA managing director (EMEA) and head of investment strategy and research Altaf Kassam.
“The idea that there exist return premia which have economic intuition and have proved their robustness empirically over market cycles makes them highly suitable for pension investors with the ability to take some active risk over long time horizons.”
However, Kassam’s last claim that factor-based approaches “makes them highly suitable for pension investors” is disputed by some. XPS chief investment officer Simeon Willis says he is a known sceptic of factor-based investment strategies.
“I have a blunt view on these and it’s fair to say that my view isn’t the consensus, but I’m quite happy with that,” he told Corporate Adviser.
“Alternative risk premia and the whole factor investment approach sounded brilliant when I first heard about it, but you need to think about what those words mean.”
Can you trust them?
Willis says that the phrase “alternative risk premia” which has been adopted by some fund houses to market factor strategies is misleading because there isn’t anything “alternative” about them. “You are investing in mainstream markets, in things to which you are already exposed. I don’t see how ‘value’ is a risk premium because I don’t see value as a risk. Let’s take a company that supposedly has more of a value tilt – is that more or less risky than a company without a value tilt? Well, not really.”
Willis says that investors will only ever receive a premium for taking genuine risks and says that fund managers claiming that passive factor strategies can do this are misleading investors as they will only ever represent the average market position.
“That is where I struggle with smart beta and factor investing approaches. Most of them aren’t really risks, they are just signals,” he says. “If they had truly identified a feature associated with outperformance, it be would be arbitraged away as people pile into the trade and the price goes up, until the market finds it equilibrium.”
Harsh words. And Willis isn’t alone. Cardano, a rival consultancy to XPS, has its own sceptic in Dev Jadeja, the company’s deputy team head of manager research.
He says: “We would urge caution if managers are describing factor-based strategies as ‘steady and secure’ as these terms can imply low performance drawdowns. There aren’t many, if any, factor strategies where this is a realistic expectation.”
Despite this, Jadeja explains that, with careful selection, there could be strategies that can still offer attractive risk-adjusted returns in an overall portfolio context.
“This is especially true when you consider that they can offer good iquidity and a lack of correlation to broader markets at increasingly competitive fees,” he says.
“At this uncertain stage in the economic cycle, any liquid strategy that can deliver reasonable risk-adjusted returns with limited market correlation should be of specific interest to institutional investors.”
Driving on
The smattering of factor sceptics has not deterred the major asset management groups from committing vast sums to developing factor-based product suites. Take UK investment house Schroders, for example, which announced it was building out its new Product, Solutions and Quant division at the start of September with the appointment of a head of quantamental investments from Barclays.
The company said the Schroders Systematic Investments team already brings “high-quality systematic, factor-based strategies to clients” and includes the
$3 billion global multi factor equity strategy and the $800 million sustainable multi factor equity strategy.
Schroders isn’t the only asset manager to have captured imaginations with a solid factor strategy proposition. Robeco says its foray into this market started 15 years ago, with the more modest “tracking-error-controlled quant strategies,” which were designed to “harvest well-known sources of excess return as documented by academics”.
However, even Robeco admits that embracing just one factor may not the best approach these days, as ac ade mi c s su gge st a combination is likely to produce a steadier performance.
“Selecting only one factor is a bit of a gamble as factor returns might be erratic in the short run,” explains Jan de Koning, a portfolio manager in the quantitative equities team at Robeco.
“Smoother returns are achieved once investors integrate multiple factors, to us that is value, momentum, quality and analyst revisions.”
New signals
The latter choice by de Koning – analyst revisions (or sentiment)
– isn’t a factor embraced by all of Robeco’s competitors, but is certainly not the most leftfield signal with which fund groups have suggested there might be a linked return premium.
Social sentiment – tracking comments about a company on social media and determining whether they are positive or negative – is one of the more modern signals which has previously been put forward as a source of assessing a company’s worth. But there are literally hundreds of more specialist examples emerging.
“Sophisticated quantitative managers are always on the hunt for new factors,” explains Cardano’s Dev Jadeja.
“In this day and age, they have at their disposal more data and quantitative processing power than ever before. Based on our experience though, it is rare for managers to discover revolutionary new factors that can be applied consistently and have robust evidence of efficacy behind them.” Jadeja says that fund groups which have been in the market the longest have started to refine the traditional factor analysis techniques to improve their chances of capturing good returns. This, he says, is to be welcomed. “We are seeing a culture of continual improvements to existing strategies. The most classical value measure for equities was devised when many businesses and industries relied heavily on tangible physical assets, like machinery to produce their products.
“Today, there are many more companies whose offering is more akin to a service and have limited physical assets. Intangible assets such as people, intellectual property and brand may be more important to the ‘value’ of those businesses and some managers are investigating ways to capture this dynamic. It is important to recognise that there are many ways managers can improve strategies without needing to find new factors.”